Banks drag Wall Street to 13-month low on Europe fears

Stocks slumped in heavy volume to a 13-month low on Monday as investors dumped bank shares on fears that Greece's worsening financial crisis could cause a large European lender to fail.

Investors pegged losses to the sharp fall in Franco-Belgian financial group Dexia, which fell 10 percent after a Moody's warning about its liquidity due to concerns about exposure to Greece.

Markets have feared European officials will be unable to prevent Greece's fiscal crisis from turning into a global banking crisis. Greece said it will miss its deficit targets this year and next, which could limit the country's ability to receive more aid.

Most investors fear that markets in Europe are going to run well ahead of politicians that are not going to be able to get any kind of reasonable solution, said Jack de Gan, chief investment officer at Harbor Advisory Corp in Portsmouth, New Hampshire.

U.S. banks have become a target for speculators. Morgan Stanley closed at its lowest since December 2008 and its cost to insure its debt has jumped as other banks hedge counterparty exposures and traders bet on the situation worsening.

The recession that wiped 12 years of gains off the S&P 500 was caused in part by a credit crisis.

We are going to have a disorderly default in Greece and there could be another banking crisis in Europe as they are undercapitalized and loaded with (sovereign) debt, De Gan said.

Morgan Stanley has been the most volatile bank in recent weeks, with the cost to insure its debt rising to November 2008 levels, according to Markit data.

The market's focus on Morgan Stanley stems from a perception about their reliance on short-term funding, said Harbor Advisory's De Gan. They rely on the credit markets and that was the downfall of Lehman and other institutions three years ago, he said.

The Dow Jones industrial average dropped 258.08 points, or 2.36 percent, to 10,655.30. The S&P 500 fell 32.19 points, or 2.85 percent, to 1,099.23. The Nasdaq Composite lost 79.57 points, or 3.29 percent, to 2,335.83.

The S&P 500 closed at its lowest level since September 8, 2010.

A stronger-than-expected reading in a gauge of U.S. manufacturing briefly lifted Wall Street stocks, but global manufacturing shrank for the first time in over two years in September, reinforcing fears of another recession.

The revelations that Athens would miss its deficit targets for both this year and next despite harsh new austerity measures will be the focus of talks as euro zone finance ministers meet to discuss the next steps toward resolving the currency area's sovereign debt crisis.

Dexia called an emergency board meeting after concerns about its exposure to Greece and a Moody's warning about its liquidity position raised pressure on Belgium and France to act.

Shares of AMR Corp , parent of American Airlines, lost a third of their market value as analysts debated the prospects for a bankruptcy filing for the U.S. airline, which lags its industry peers.

About 10.9 billion shares traded on the New York Stock Exchange, NYSE Amex and Nasdaq, about 36 percent above the year's current daily average of 7.98 billion.

Declining stocks outnumbered advancing ones on both the NYSE and Nasdaq by a ratio of about 10 to 1.